Month: November 2017

Currencies enable commerce, acting as a recognised standard unit of exchange; they are closely associated with nation states – usually being either created or controlled by governments, within their (geographic) spheres of economic and legal influence. What is interesting about the early cryptocurrencies is they have been able to address very large communities – crossing many national boundaries in the process – and although we have seen certain countries seeking to dissuade the use of cryptocurrencies (for example China and Korea) – the growth of the populations ‘using’ (in the widest possible sense of the word) continues. In this respect cryptocurrencies are functioning much like the multinational currencies of the past, for example the Spanish Real de a Ocho or the Bohemian Thaler, transcending national boundaries in their use as a medium of exchange. What is also thought-provoking in this comparison is the Real and Thaler were made of gold and silver respectively – which many would recognise as having tangible value during their period of dominance – versus cryptocurrencies which would be considered ‘intangible’ under most classical definitions.

I conform to the view that, having moved away from being based on a tangible commodity, the value of modern currencies is defined by their ability to enable exchange – and thus those with the most developed usage networks or economies behind them are the strongest currencies (not necessarily from an exchange rate perspective, but from a longevity perspective). In order to maintain the value of a currency, a government must ensure it is linked to a strong economy and is well used (both domestically and internationally).

Adam Smith and Tokenisation

This brings me to Adam Smith, who put forward the following roles of government:

Defence

Justice

Public works and institutions

Why? Because like national currencies, cryptocurrencies are also governed – and there is a compelling argument to view the relative value of cryptocurrencies and cryptotokens on the basis of the governance regimes that manage their use creation and use. These mediums of transaction can be apportioned value in line with their relative merits, when compared to Smith’s framework.

Defence of a territory (within which a currency operates) is the first responsibility of the state – and equally it should be the first consideration of those seeking to develop new cryptotokens. If the environment within which the token is used cannot be defended, the token will lose its value (both as a store of value and as a mechanism for enabling transactions). But what are we defending from? There are a number of things that immediately come to mind:

More ‘attractive’ environments for use e.g. Coinbase versus Mtgox (more attractive security, in this case)

(Public knowledge of) poor integrity e.g. on the fork date of Bitcoin Gold, it was well publicised that the codebase does not offer protection against replay attacks (amongst other issues)

For the developer of a cryptographic token, the first question that should be asked is ‘how do I ensure the use case for this token is defensible in the long term, as countless other tokens will likely be brought to market to address the same use case(s) I am addressing if I am successful?’

The second role of government is the delivery of justice. In the days of yore, justice and defence were intrinsically linked – on the basis of manpower availability. A community’s ability to defend itself was proportionate to:

total manpower

its approach to defence

its technological capacity

Manpower and science would grow in permissive environments – think of the first Persian Empire’s reputation for legal process, scientific advance, and military might. Contrast that with the fall of the Ottoman Empire hundreds of years later, which was a divided state with clearly distinct (and often marginalised) groupings in the population – often conflicting with the state’s own laws, which were poorly enforced.

So how is this relevant to the development of a cryptotoken? Bitcoin was not the first form of electronic currency (see Chaum’s ecash for the first successful implementation) – but it does have a strong, simple governance model which ties the ‘miners’ into the model and incentivises them to behave in line with the community’s needs. For a token to be successful, I would suggest developers consider a number of points (in line with delivering ‘justice’):

Incentive mechanisms – how does the governance model encourage adopters to move to using the token?

Dissuading poor behaviour – for example rent-seeking – is there a methodology that prevents free-riding or market abuse? The token developer should consider their own potential role here (see the change in Ripple’s value in May 2017 when 55 billion of retained XRP were placed in escrow with a defined plan for their use)

Both of these points are congruent with how ‘laws’ operate within a nation – they either incentivise or dissuade behaviors.

Smith’s final role is that of public works and institutions – Smith advocated these for the facilitation of commerce and trade. The time has now gone where a token can be created as a standalone, without a defined use, and still be attributed value. Token creators must think as much about facilitating the use, as the use itself – for example:

Is the token launched such that speculators can engage with it in a secondary market via engaged exchanges?

Does the token creator provide ‘the market’ for the use case? For example, the Bristol Pound has a use case because Bristol has onboarded its consumers and retailers – but David Coin has no use case – I have no consumers nor suppliers prepared to use it.

Cryptotokens are, to my mind, the best current example of Metcalfe’s (and Beckstrom’s, and Reed’s, and Sarnoff’s) law on the value of networks.

Taxation

This brings me onto the second part of this blog:

How does the state pay for its functions, and what does this tell us about how cryptotoken communities can pay for themselves?

The simple answer, to my mind, is: tax.

A nation state taxes its citizens and economic operators, and the purpose of this tax revenue is the delivery of the functions of state. Of course, the state must be aware:

Of Frédéric Bastiat’s comments on the state

Of the impact of rent-seekers

That if a ‘tax’ model is implemented to provide revenue to enable its functions, this is not done in a way that alienates its users (/citizens).

There will always be a temptation in any token-enabled environment to implement a simple tax model – 1% of all transactions, for example. However, history has already shown that a simple levy is not the most effective approach – and in fact any modern tax system is used to both encourage and dissuade activities which, whilst legal, are considered more or less attractive to the population. They can also be extremely complex (the US Federal Internal Revenue Code has 9834 sections; there are over 100 HMRC tax manuals) – which represents the extent to which the modern nation seeks to bestow benefit for certain activities, and discourage others.

The creators of cryptotoken(s) should bear these points in mind – as the governance model applied at the establishment of a new community have, to date, been shown to be difficult to change without significant disruption to the underlying population. Recall the warnings not to transact in bitcoin for a number of days either side of the Bitcoin Cash fork. Whilst mechanisms have been built into many cryptotoken models, I do believe these will continue to evolve in the coming years.